Why Conoco May Be A Tricky Dividend Stock These Next Few Years

Summary

By holding the dividend at $2.64 after spinning off Phillips 66, Conoco raised its payout ratio from 30% of net profits to 44% of net profits.

Most likely, Conoco will try and lower this payout ratio to the 25-30% range over the long term to allow for the capital projects necessary to fund growth.

The implication is that, for the next several years, earnings per share may be increasing faster than dividends as the company recalibrates to a more appropriate long-term payout ratio.

After spinning off Phillips 66 (NYSE:PSX) in 2012, Conoco (NYSE:COP) management made an important decision: they chose to keep their dividend at $2.64 per share. This was significant because the removal of Phillips 66 from the Conoco corporate umbrella reduced Conoco's earnings per share from $8.76 in 2011 to $5.91 at the time of the spinoff. In other words, by keeping the payout steady without Phillips 66 on the balance sheet, Conoco effectively raised its dividend payout ratio from 30% in 2011 to 44% after the spinoff.

Now that Conoco is an exploration and production company, there can be an inclination to get the payout ratio more in line with the 25-30% range rather than the nearly 40-50% range that the company has been in since divesting Phillips 66.

This is why I describe Conoco as a tricky stock over the next few years: the overall profit growth should be quite satisfactory (and if the share price matches the profit growth of the firm, then the capital appreciation should be nice as well), but the dividend growth may be materially lower than the profit growth as Conoco's Board may readjust its payout ratio down to the 30% of profits range that is suitable for an E&P energy company. More succinctly, Conoco may be an excellent holding for the next five years, and the dividend may be a meaningful part of the story, but steady 8-12% annual dividend growth may not be in the offing.

On the earnings growth front, Conoco is doing many things well. The company is increasing the margins of its overall projects, and it is increasing its overall production rates. That's all you can ask of an oil company. The pre-spinoff Conoco had an operating margin in the 26-28% range in the years preceding the financial crisis, and an operating margin in the 18-21% range in the financial crisis years that included having Phillips 66 under its corporate umbrella. Now that Conoco can focus on growth in the Bakken Fields (which are lucrative from the point-of-view of trying to increase margins), Conoco has seen its operating margins increase to the 40-44% range in the years after the Phillips 66 spinoff (the current figure stands at 41.3%).

Given that Conoco has increased its "new project" production by more than 38% in the 2014 calendar year, you're starting to see the net profit margins increase in a substantial way as well. In the years in which Phillips 66 was part of Conoco before the recession, the net profit margins were in the 6-8% range every year. During the financial crisis, the net profit margins fell to the 3.5-5.0% level. Since divesting Phillips 66, Conoco has increased its net profit margins to the 12.0%-14.7% level (note: the current 14.7% net profit margins are the highest figures that Conoco has been reporting in the past two decades, indicating that the combination of the Phillips 66 divestiture and the 2.5 billion barrels of reserves in the Eagle Ford fields has enabled Conoco to not only increase production, but do it in a way that the operations earn higher margins as well).

For long-term holders of Conoco, the dividend growth has been a large part of the story: it has increased by 13.5% in the past ten years (the current $0.69 quarterly dividend is now more than Conoco paid out in entirety in the year 2000, plus you picked up shares of Phillips 66 which pay out its own dividends as well). The tricky part, though, is this: earnings grew by 10% over that time frame, and Conoco is now less integrated than it was before the spinoff, and will likely need to recalibrate to a lower payout ratio to recognize the volatility of profits and significant capital that must be set aside for new exploration projects.

In short, Conoco should continue to be an excellent asset to own; production is increasing at 3-4% annually, and net profit margins have improved to the generational high level of 14.7%. The improving reserve figures at the Eagle Ford and Bakken Fields have increased Conoco's total reserves to almost 9 billion barrels of oil and oil equivalents. This is good news for shareholders - earnings per share, and presumably the share price, should be increasing at a healthy clip in the next few years. However, the dividend growth rate may lag that substantially as the payout ratio needs to adjust downward (generally, the most painfree way to "fix" a payout ratio is to give dividend increases that trail the earnings per share rate in good years). For the next few years, it would be wise for long-term dividend investors in Conoco to evaluate the business as a whole when making their decisions, rather than any potential disappointment with a dividend that temporarily be growing slower than they might like.

Disclosure: The author is long COP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.